Our investment behaviour is a tangle of contradictions. Whilst there is an understandable desire to draw clean lines of causality – X bias leads to Y action – things are rarely so simple.
One example of such confusion is the inherent friction between keeping faith with your investment principles and the problem of escalating commitment. I often try to extol the virtues of holding a set of well-defined investment principles and maintaining them through the vicissitudes of economic and market noise. It is clear, however, that a great failing for many of us is becoming increasingly devoted to a particular view in spite of reams of disconfirming evidence about the validity of that perspective.
Escalating commitment is a situation where an individual or a group persist with a course of action despite facing negative results and feedback. This topic has been well covered by psychological research and there are some excellent meta-analytic reviews of the studies carried out in this area[i] [ii].
A research paper by Theresa Kelly and Katherine Milkman[iii] specifies four primary explanations for our propensity to double-down in the face of adversity:
Self-Justification Theory: Repudiating previously held views is painful and creates a dissonance between our failure and belief in our own competence.
Confirmation Bias: We actively seek information that corroborates our view or course of action. We might be wilfully blind about the fact we are failing.
Loss Aversion: The crystallisation of lost time, money and credibility is deeply unpleasant. We weigh the sunk costs heavily when deciding whether to persist.
Impression Management: How we are perceived by others is crucial to our self-worth and (in many cases) our career. Changing our mind means admitting that we have erred and risks us being perceived as ineffectual or inconsistent.
The issue of commitment escalation is a particular challenge for investors because the feedback we receive (typically in terms of profit and loss) is noisy and erratic. Markets don’t consistently reward good decisions. Sometimes they take time to work; sometimes they don’t work at all. Whilst in many fields the failure of a project or decision is unambiguous, for investors it can be difficult to tell whether we are wrong or just not right yet.
This feature of financial markets creates a stark juxtaposition between the benefit that can accrue from persevering with sound investment principles, and the cost of the failure to abandon poor decisions. How can I tell if I am diligently keeping faith with my investment approach or naively escalating commitment?
Is it an Investment Principle or Investment View?
The most crucial distinction to draw is between what constitutes an investment principle and what constitutes an investment view.
An investment principle is a belief that informs our decision making – for example, I may believe in regular rebalancing, or in long-term holding periods. All of our investment decisions should be framed by these principles.
By contrast, an investment view is some form of explicit or implicit prediction or forecast about the future. For example, it might be that there will be a recession in 2021 or that US equities will underperform other developed markets next year.
In reality, for most decisions it is not possible to specify a binary classification between an investment principle and an investment view; rather there is a spectrum between the two extremes.
At one end, an investment principle should be broad and supported by robust and clear evidence, and assumed to be invariable. Of course, there may be times where an investment principle shifts or evolves but the threshold for such a change should be very high. Commitment to a principle should generally be seen as a virtue.
At the other end of the spectrum is an investment view, which is specific and temporary. Whilst it should also be supported by evidence, the threshold for change based on the receipt of new information should be reasonably low. The probability of being wrong is significant and unwavering support is damaging:
|Investment Principle||Investment View|
|Threshold for Change||Higher||Lower|
It is easy to think of examples at each extreme – I don’t buy funds with leverage (principle) / the market will fall 20% next year (view) – but many of our investment opinions fall somewhere in-between. For example, let’s assume I believe that smaller companies provide a long-term return premium and are inefficiently priced. As a result I place an active allocation to this area within my portfolio. This perspective is neither purely a principle nor a view. It is structural long-term rule, but is also specific and based on mixed evidence.
The closer an investment decision is to being defined as a view, the more the escalation of commitment becomes a challenge. Whilst we should be willing to reconsider either a principle or view in light of new evidence, by definition our commitment to principles should be significantly more durable than our willingness to persevere with an investment view.
The escalation of commitment is particularly problematic for investors when they come to be identified by an investment view rather than principle. Warren Buffett can be defined by a set of core investment principles, but many investors become known for a view. This is most common with bearish prognosticators consistently forecasting recessions or severe market declines. In such situations individuals seemingly operate in ignorance of new contrary evidence and their identity becomes intertwined with their particular outlook meaning that it becomes impossible for them to recant**.
How to Avoid the Escalation of Commitment
With any investment decision (wherever it resides on the spectrum between view and principle) one of the best protections against the escalation of commitment is a decision log. This is a simple approach but one that seems to be applied sparingly. Although the precise structure can vary; in broad terms a decision log should be a concise document detailing the key drivers of a particular decision at the time we are making it. This should include aspects such as: what the decision actually is, the time horizon involved, the key supporting evidence and potential risks / threats.
Not only does a decision log provide some protection against our hazy and unreliable recollections of past investment decisions; it should also mitigate the danger of us becoming increasingly committed to an investment view. If we are specific about the key drivers of a decision at the point of initiation it becomes far more difficult to become emboldened in our conviction as the evidence wanes. Creating a decision log also forces us to consider the prospect of being wrong at the very start of a position, which subsequently makes it (somewhat) less damaging to our ego if this negative outcome comes to fruition.
Using a decision log is not, however, painless. Looking back at what we previously believed when we made an investment decision can be a unpleasant experience; it’s far more agreeable to allow your memory to construct a flattering story about it. This is perhaps why they seem something of a rarity.
There is no simple way to manage the escalation of commitment. Taken to its extreme, bluntly attempting to negate its influence would lead to us all becoming short-term investors, destroying value at the first sight of trouble and abandoning sound investment decisions based on the meaningless fluctuations of markets. Contrastingly, ignoring it would make us prone to increase conviction in failing ideas with scant regard for new evidence. A more measured approach is required, where we better understand the nature of each decision we make and are clear about the reasons we are making it.
* Investment principles can of course be wrong and therefore commitment to them a negative. I am assuming here that the investment principles are robust and well-founded.
** Whilst becoming defined by a certain viewpoint may often be imprudent and costly in investment terms, it can be a rational course of action for an individual pursuing such a strategy. This is particularly true for those of a bearish disposition who appeal to the fearful nature of risk averse investors and of course will, one day, be right. Also, the half-life of credibility for market crash / recession forecasters seems to be far longer than those of a more positive bent.
[i] Sleesman, D. J., Conlon, D. E., McNamara, G., & Miles, J. E. (2012). Cleaning up the big muddy: A meta-analytic review of the determinants of escalation of commitment. Academy of Management Journal, 55(3), 541-562.
[ii] Sleesman, D. J., Lennard, A. C., McNamara, G., & Conlon, D. E. (2018). Putting escalation of commitment in context: A multilevel review and analysis. Academy of Management Annals, 12(1), 178-207.
[iii] Kelly, T. F., & Milkman, K. L. (2013). Escalation of commitment. Encyclopedia of management theory, 257-260.